Index Funds, ETFs and Fund of Funds: The Other Group

The scheme categorisation framework set by the Securities and Exchange Board of India (SEBI) sorts every mutual fund scheme into groupings, and one grouping collects schemes defined by how they invest rather than by what they hold. Index funds, exchange traded funds and fund of funds sit there. Each still sits in exactly one category, and each still carries a name that has to match where SEBI places it.

Here is what sits underneath that. Every mutual fund scheme sold in India lands inside a framework somebody else wrote. SEBI wrote it, SEBI changes it, and an asset manager does not get to invent a fresh category for a scheme it would like to launch. The categorisation framework is the ground everything below stands on. Its proof is the regulation itself, read at the source rather than recalled. The framework is a shelf plan and not a shopping list: it states where a scheme has been put, and it never states whether to hold it.

One scheme runs through the sections below from end to end. Girnar Asset Management Limited, an invented asset manager, operates the Girnar Broad Market Index Fund, an open ended scheme that follows a broad published indexA list of holdings plus a rule for how much of each one counts, maintained and republished by whoever writes it. which is never named here. The same asset manager also operates the Girnar Large Cap Equity Fund, whose name is used later for one narrow purpose. Kalyani Bhagat manages the equity scheme and Sohail Merchant heads operations.

Three things are taken as settled here. A scheme is a separate pool of property with its own accounts, run by an asset manager and held in trust by a trustee company for the people who hold its units. A unit is a share of that pool, and the value per unitWhat the scheme's property is worth after its liabilities, divided by the number of units in issue. is struck by dividing the value of the pool after its liabilities by the units in issue. A purchase creates units and an exit cancels them. All three are covered separately.

One more thing is settled, and it matters more in this guide than almost anywhere. A return means nothing until its period and its basis are known. Two returns appear below, one belonging to an index and one belonging to a scheme, and they stand on bases that are not the same. The difference between the two bases is too load bearing to leave until later, and a section further down is given over to it.

What does the framework claim, in the four statements that carry the rest?

Four statements carry the whole of what follows. First, categories exist and SEBI sets them; they are not conventions the industry drifted into and not labels an asset manager chooses for itself. Second, a scheme sits in exactly one category. Where a given scheme has been put therefore always has an answer. Third, the category limits what the scheme may hold, so the category is a constraint on the scheme and not merely a description of it. Fourth, the scheme's name has to match the category it sits in. A name is therefore a weak clue about holdings and a strong clue about placement.

All four statements are stable, and every value that would fill them in is a SEBI condition that moves. How many groupings the framework carries, what each is called, the least a scheme in a given category must hold, how long anything must be held: those are all values, all set by SEBI, and all read at sebi.gov.in on the day they are needed. A category in its own right is covered later in this sequence. The four statements serve as scaffolding for now.

Why does a framework built on holdings need a grouping for method?

Because most groupings answer one question and some schemes do not answer it. The question most groupings ask is what does this scheme hold, and for a great many schemes that is exactly the right question: the answer separates one shelf from another cleanly and a reader knows something real once they have it. But a scheme that copies a published index is poorly described by its holdings. The holdings are a consequence of a rule rather than a starting point. A scheme that holds units of other schemes is poorly described by its holdings too. Its holdings are other schemes, and a list of schemes reveals almost nothing on its own.

A household sorting a kitchen faces the same problem. Most of it sorts by ingredient. An ingredient is what a person is looking for when they open a cupboard: rice here, pulses there, spices in the third row. Then somebody puts a pressure cooker in the kitchen. A pressure cooker is not defined by what goes into it but by what it does to whatever goes into it, so the ingredient question stops working. A different kind of shelf is needed, and that shelf is not a leftover corner: it is a proper place with a proper principle. A framework built only on what a scheme holds has nowhere to put a scheme whose defining feature is its method, and this grouping is the answer to that problem rather than an afterthought beside it.

What is an index fund, and what makes it a scheme rather than an index?

Start with the index. The index is the part people quietly assume they can hold. A published index is a list of holdings together with a rule saying how much of each one counts, maintained and republished by whoever writes it. A published index is a measuring stick. Nobody can hold a measuring stick. There is no account into which an index can be delivered, no unit of it to buy, and nobody charges anything for its existence as a number.

An index fundA scheme that holds what a published index holds, in the proportions the index sets, so its holdings follow a rule rather than a person's selection. is what makes the measuring stick holdable. An index fund is an ordinary scheme with an ordinary pool of property and an ordinary value per unit, and its distinguishing feature is a promise about method: it holds what the index holds, in the proportions the index sets. When the index changes, the scheme follows. The person running it is not picking holdings on their own judgement, and the scheme's document says so in advance.

Now the part worth carrying away. A shopper who walks into a market with a printed list and buys exactly what the list says has not stopped making decisions. The shopper made one large decision, to follow that list, and from then on the deciding sits with whoever wrote it. If the list is wrong, the basket is wrong, and no amount of faithful shopping repairs it. The choosing did not disappear when the person running the scheme stopped choosing; it moved to whoever writes the index rules, and that is a different place rather than an empty one.

Two conditions attach to a scheme of this kind. There is a condition about the least a scheme of this kind must hold in the instruments its index carries. There is a condition about how closely its holdings must stay to that index. Both are set by SEBI, both are the sort of thing revised by circular, and both are read at sebi.gov.in on the day they are needed.

What is an exchange traded fund, and what is different about how it is bought?

An exchange traded fundA scheme whose units are listed on a stock exchange, so a holder can buy them from another investor rather than only from the scheme. is a scheme whose units are listed and change hands on an exchange. Listing changes how a holder gets in. With an ordinary open ended scheme, a purchase reaches the scheme, the scheme creates units, and the price applied is the value struck for the relevant day. With units on an exchange, a buyer meets a seller, the two agree a number between themselves, and the units already exist: they move from one account to another rather than being made.

So there are two numbers in the picture at once. There is the value per unit, struck by the scheme from what its property is worth after liabilities. There is the traded priceThe price at which two investors on an exchange actually agreed to hand units from one to the other.. The traded price is whatever a buyer and a seller settled on. The two numbers come out of two different processes. One is an arithmetic result computed by the scheme; the other is the outcome of two people agreeing. An exchange traded fund puts two prices in the picture where an ordinary open ended scheme has one, and neither of the two is a mistake when they differ.

There is a second route into units of this kind, in which units are created and cancelled in bulk directly with the scheme rather than bought from another investor. The bulk route exists, it matters, and it is covered separately. Everything about how a listed unit is quoted, when it may be dealt in, and which conditions attach to a listing is set by SEBI, and the current position is read at sebi.gov.in.

What is a fund of funds, and what is it actually holding?

A fund of fundsA scheme whose holdings are units of other schemes rather than shares, bonds or other instruments held directly. is a scheme whose holdings are units of other schemes. Its list of holdings shows no shares and no bonds. The list shows units, and behind each of those units is another scheme with its own pool of property, its own accounts and its own value per unit. Only by looking through that second scheme does a reader reach anything real.

A holder therefore sits two layers away from the underlying holdings, and the second layer is not cosmetic. Each lower scheme strikes its own value per unit after its own charges have run against its own assets. The upper scheme then values its holding of those units at whatever the lower schemes struck, and works out its own value per unit from there. Everything charged at the lower layer has already been borne by the time the upper layer strikes its own value, so the layers stack whether or not anybody counts them.

Here is the household version. A neighbourhood savings arrangement collects a monthly amount from thirty households and does not put the money to work itself; it hands the money to three other arrangements and holds a claim on each. A household in the first arrangement is exposed to whatever those three are doing, at one remove, and whatever it costs to run those three has already come out before the first arrangement works out what each household's share is worth. Nothing is hidden. The cost is simply two floors down instead of one. How a charge at two layers reaches a holder in rupees is covered separately.

Why do these three sit together when they behave nothing alike?

Set the three side by side and the differences are not small. One holds what a list tells it to hold. One is bought from a stranger on an exchange. One holds units of other schemes and never touches a share directly. The three differ in what they hold, in how a unit reaches a holder, in who did the choosing, and in how many prices are in the picture on any given day. Sorted by behaviour, no sensible arrangement would put these three in one place.

An index fund, an exchange traded fund and a fund of funds sit together because of the kind of definition each carries. Every one of them is defined by a method of investing rather than by an asset class. A method of investing is the shared principle, and it is the only shared feature on the list. The one property the members of this grouping have in common is the sort of definition each one carries, so a reader who expects a grouping to describe how a scheme behaves will misread this one every single time. Read it as a statement about definitions and it is exact; read it as a statement about behaviour and it is wrong in three directions at once.

Does a scheme in this grouping still sit in exactly one category?

Yes, and being defined by a method changes nothing about that. An index scheme that copies an index made of shares is not thereby an equity scheme in the framework's sense. The scheme holds shares, certainly, and anyone reading its list of holdings will see them. But holdings are evidence about holdings. Holdings are not a conclusion about where the framework has put the scheme, and the two questions have different answers reached by different routes.

The route to the second question is short. The grouping a scheme sits in is a placementThe one category in the framework that a scheme has been assigned to, stated in the scheme's own document rather than worked out by a reader. SEBI makes and the scheme's own document states, rather than an inference a reader draws from looking at what it holds. It is read, not derived. And when the scheme's document and a reader's inference disagree, the document is right and the inference is the one to throw away. The document reports a decision, and the inference only guesses at one.

The same distinction is why the name matters. The scheme's name has to match the category the scheme is placed in, and what a name is allowed to claim is itself a SEBI condition. The Girnar Large Cap Equity Fund is a useful case precisely here: the words in that name are a marketing name that has to match a placement, and they are not a definition of what large capitalisation means. A capitalisation band is settled by SEBI together with the classification list the Association of Mutual Funds in India (AMFI) publishes, and nothing about it is decided by looking at the scheme.

What does the placement card for the invented index scheme look like?

Here is the whole idea made into something that fits on a desk card. A placement card for one scheme has two kinds of row on it. Some rows carry facts about the scheme itself, and those come from the scheme's own record. Other rows carry rule-set conditions, and those come from SEBI or from the classification list AMFI publishes. The second kind is left blank, with the name of the body that sets it written inside the blank instead of a value.

Notice what the last row does. The card carries no net assets for the index scheme, no unit count and no folio count, so there is nothing to divide and nothing to divide it by. The honest response is a blank with the reason written next to it. A blank sends the reader to the source and a wrong value stops the trip altogether, so a card whose rule-set rows are filled in from recollection is worse than a card with blanks.

Which two bases are the index return and the scheme return standing on?

Two figures, and they do not stand on the same ground. The index this scheme follows returned 12.40 per cent over the stated year, and that figure carries no costs at all. An index is not investable, and nobody pays anything to hold one. There is no expense ratioThe charge running against a scheme's own assets, quoted as a percentage of those assets a year. inside an index return, and there never can be. The scheme returned 12.12 per cent over the same year, and that is a net returnA return computed from values that already carry the scheme's charges, so nothing is deducted from it afterwards.: it is computed from values that already carry the scheme's own expense ratio of 0.20 per cent of net assets a year, so nothing gets deducted from it afterwards.

The subtraction comes before any reaching for the expense ratio. 12.40 less 12.12 is 0.28 percentage points. The gap of 0.28 points is bigger than the 0.20 per cent of costs, so the costs do not account for the whole difference. Taking the costs out shows what remains: 12.40 less 0.20 is 12.20, and 12.20 less 12.12 leaves 0.08 percentage points unexplained. The remaining 0.08 has a real answer, and it is covered separately.

A comparison that names only one of the two bases has already gone wrong, whatever the numbers do afterwards. And the figures themselves claim very little: one year, one invented scheme, one unnamed index, and nothing in them settles anything about how any approach performs in general. If somebody wants to make that larger argument, this record is not the evidence for it and was never assembled to be.

Where does every rule-set value actually live?

In one place, and it is not this walkthrough. Which grouping each of the three scheme types is placed in and what that grouping is called: SEBI. How many groupings the framework carries: SEBI. The least a scheme must hold in the instruments its category names: SEBI. How closely a scheme following a published index must stay to it: SEBI. The claim a scheme name is allowed to make, and the rule tying a name to a category: SEBI. How many schemes one asset manager may run inside a single category: SEBI. All of them are read at sebi.gov.in, and all of them are changed by circular on SEBI's own timetable rather than a reader's.

One item named above is a classification rather than a rule, and it has a different address. The list against which a scheme's holdings are measured, letting a holding be placed in one band rather than another, is published by AMFI at amfiindia.com. AMFI publishes it; SEBI makes the rule that the list is used. Keeping those two straight matters. Treating an industry body's publication as the rule itself is how people end up citing the wrong authority for a requirement.

A value printed in a reference does not merely become dated when it changes, it becomes wrong, and the route therefore matters more than the value. A reference that says a condition exists and names its keeper stays correct through every revision. A reference that prints the condition's current value is correct until the morning it is not, and it gives no signal on that morning.

Girnar Asset Management Limited, the Girnar Broad Market Index Fund, the Girnar Large Cap Equity Fund, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.